For a small northern country, Canada has enjoyed the economic benefits of a uniquely successful auto manufacturing industry, one that is far out of proportion to our population or our market. In 1999, when our auto indus- try peaked, Canada ranked as the fourth-largest automaker in the world. The auto industry generates well-known econom- ic and fiscal spinoffs, which make it an attractive target for government efforts to recruit investment and production. This makes it all the more extraordinary that Canada became a world automotive leader. The 1990s were the best decade ever for the industry in Canada; the industry invested an incredible $35 billion in new plant and equipment here, and created 35,000 new high-wage jobs in the process.

With a booming auto industry generating billions of dollars in new incomes ”” and tax revenues ”” each year, it is not surprising that government policy makers came to take this industry’s disproportionate presence in Canada for granted. But that was a mistake. The historical development of Canada’s auto industry was not the result of private business decisions or free market forces. It was clearly the result of a strategic and active policy effort by Canadian governments, stretching back decades, to stimulate the development of this desirable and beneficial industry. With the industry firing on all cylinders in the 1990s, policy makers forgot this lesson. And so the atten- tion and resources devoted to the industry by government diminished, just as the industry was reaching a turning point.

In four short years, since peaking in 1999, Canada’s auto industry has entered a sustained and serious downturn. The dimensions of this decline are startling.

• Vehicle assembly in Canada declined by nearly 20 percent dur- ing this period. Canada has already slipped to seventh among global automakers, and indica- tions suggest we could fall off of the list of top 10 producers within five years ”” surpassed by boom- ing auto producers like China, Brazil, and Mexico.

• In the 1990s, Canada typically assembled twice as many new vehi- cles as were sold in the Canadian market. But this ”œassembly-to-sales” ratio fell to 1.5 last year, and will fall further in the years to come. Correspondingly, our foreign trade surplus in auto- motive products, which has been crucial to Canada’s overall trade performance in recent years, has fallen by at least one-third. The proportion of North American sales accounted for by Canadian- assembled vehicles fell from 16 percent in 1999 to 13 percent in 2002 ”” and once again, things will get worse before they get better.

• Four major Canadian automotive assembly plants face closure within a two-year period, eliminating a combined total of about 7,000 assembly jobs. GM’s plant in Ste- Théré€se, Quebec, closed in 2002. In Ontario, DaimlerChrysler’s van plant in Windsor closed in June of this year. The Navistar truck assem- bly plant in Chatham faces serious risk of closure. Finally, the Ford pickup truck plant in Oakville is scheduled to close in 2004. Our entire automotive assembly indus- try comprises only about 15 assembly plants, each of which is incred- ibly important to overall automo- tive output and exports. The loss of one-quarter of those plants within two years is a serious blow by any definition.

• Even more worrisome has been Canada’s failure to attract its share of new assembly investments, as the geographical centre of gravity of the North American auto industry shifts southward. Despite perpetual con- cerns that the auto industry already has too much capacity, at least 18 new auto assembly facilities have been built or announced in North America since 1990. Only one of those plants was located in Canada (see Figure 1): Honda’s second assembly plant at Alliston, Ontario. Most of the rest were located either in low-cost Mexico, or in the new auto-producing states in the south- east of the US (especially Alabama and Mississippi), where generous government subsidies have attract- ed new auto investments from tra- ditional auto-producing regions. If we are not attracting a proportional share of new investments, at the same time as many of our existing facilities are shutting their doors, then it is clear that Canada’s auto industry has only one way to go, and that is down.

• Auto-assembly employment has declined by 12 percent, or about 6,000 jobs, since 1999. More job losses will come as the scheduled plant closures take effect, along with slower production levels at other plants. Economic studies suggest that each of these jobs in a major auto assembly plant supports a total of 7.5 jobs in the regional and national economies, through a vari- ety of spinoff channels. This sug- gests that the total Canadian job loss resulting from the current auto- motive downturn is already in the order of 45,000 jobs, with more to come. Since auto jobs are relatively well-paying, the consequent decline in personal incomes, consumer spending and government revenue is all the greater. Overall employ- ment in the auto parts sector has held relatively steady since 1999. But given the increasingly tight geo- graphic links between parts-makers and assembly plants, it is inevitable that the Canadian parts industry will also shrink if our assembly capacity continues to decline.

How do we explain the surprising turn in fortunes of Canada’s auto industry, the sudden reversal from expansion to contraction? By any measure the industry is mired in its worst downturn in a generation. Not since the reces- sion of 1981-82 has the industry experienced such a marked and sustained decline ”” and that downturn occurred in the con- text of a continent-wide collapse in new vehicle sales. The present downturn, on the other hand, has occurred in the context of strong consumer demand conditions. New vehicle sales in Canada set a record high in 2002, while US sales did the same in 2001. The challenges facing Canada’s auto producers are clearly more structural than cyclical ”” although if continental vehicle sales turn down in the coming years, as most forecasters expect, then those problems will quickly become much worse.

A number of evolving factors have contributed to the auto industry’s recent trials and tribulations. Canada’s industry ”” both the assembly plants and inde- pendent parts producers ”” is heavily dependent on the operations of the tra- ditional ”œBig Three” manufacturers (GM, Ford, and DaimlerChrysler). Big Three market shares have been fiercely chal- lenged by other producers based in Asia and Europe, on the strength of both rap- idly growing imports and increases in their North American production. Since over 80 percent of Canadian assembly, and an even larger share of parts produc- tion, depends on the Big Three, their for- tunes inevitably determine the overall trend of the Canadian industry.

Within North America, emerging trends in competing jurisdictions have undermined Canada’s appeal for new investment. Mexico’s entrance into the NAFTA, and its rapidly improving technical, transportation, and mana- gerial infrastructure have allowed automakers to take fuller advantage of labour costs that are one-seventh those of Canada. Poor quality and productiv- ity once offset the appeal of low Mexico wages, but this is no longer the case. Meanwhile, US jurisdictions began to offer unprecedented invest- ment incentives, typically accounting for up to one-third of the capital cost of a new manufacturing facility, to automakers and major parts suppliers. This practice has been most aggressive in the US southeast, but extends to other regions of the US as well.

Technological and managerial innovations place added pressure on investment and employment levels in the auto industry. Automakers, anx- ious to reduce their unit capital costs in a fiercely competitive industry, are seeking to boost average capacity uti- lization through the use of more flexi- ble technology that allows them to produce several different vehicles on a single assembly line. This implies that there may be fewer assembly plants in operation in future, and so each plant will be all the more important to total output and employment levels in any competing jurisdiction.

This convergence of challenges has emerged to confront Canada’s auto industry at the very moment when the central policy tool which guided the industry for decades was being disman- tled. The Canada-US Auto Pact, signed in 1965 by Lyndon B. Johnson and Lester B. Pearson, laid the foundation for Canada’s modern auto industry. It allowed for tariff-free bilateral trade in finished vehicles and parts, but only if automakers met target levels of Canadian production and content. The Auto Pact ushered in a period of rapid investment and expansion in Canadian facilities in the late 1960s and 1970s, as automakers acted to meet those targets and preserve their tariff-free status. By the mid-1980s, the Auto Pact require- ments were no longer binding on new investment decisions, because all mem- ber companies were operating well in excess of the mandated minimums. Much of the power of the Auto Pact was removed by the Canada-US free trade agreement and the subsequent NAFTA (which allowed for tariff-free automotive trade without any Canadian-content strings attached). The World Trade Organization deliv- ered the final blow when, at the behest of Japanese and European automakers, it ruled that the Auto Pact violated var- ious WTO commitments, and ordered the policy dismantled (or else Canada would face countervailing duties from Japan and Europe).

Coincidentally, the WTO’s first rul- ing against the Auto Pact was delivered in 1999 ”” just as Canada’s auto industry was peaking after a decade of unprecedented growth. Most of the decline in investment and employment in Canada’s auto indus- try since then would clearly have occurred anyway, even if the Auto Pact were still in effect, so the importance of the WTO decision should not be overstated. Nevertheless, the Auto Pact ruling is symptomatic of a broader pas- sivity in industrial policy making by Canadian governments which has more directly and visibly contributed to the current downturn.

Even when the Auto Pact retained force, Canadian governments had always used other policy levers in a proactive man- ner to leverage crucial investments in Canadian automotive production. The Canadian operations of Toyota and Honda, which now account for about 20 percent of Canadian assembly, were recruited through creative policy interventions. These include a custom-made program to remit duty payments on imported auto parts and an implicit trade threat (reinforced by federal actions earlier in the 1980s, when Japanese vehicle imports were held up for ostensible ”œinspection”) that continued market access for these companies could be dependent on Canadian investments. Every major automotive investment in Canada until 1995 was assisted by a range of tailored federal and provincial government incentives including infrastructure and training grants, tax abatements, and outright cash subsi- dies. Indeed, there is not one auto assembly plant in Canada that cannot trace its ”œroots” to a combination of proactive government investment incentives and the use or threatened use of trade policy levers.

Since 1995, however, both the Ontario and federal governments with- drew from this active role in stimulat- ing and facilitating major investments. In Ontario’s case, the motive was ideo- logical: the Conservative government of Mike Harris was committed to creat- ing a very business-friendly tax and regulatory regime, but also to eliminat- ing any active role for government in leveraging important investments or other business decisions. At the federal level, the motive was more fiscal than ideological: the whole range of business subsidy programs (traditionally deliv- ered through a range of departments and programs including industrial development, employment insurance, and training) was dramatically scaled back in the budget-cutting of the mid- 1990s. In trade policy, meanwhile, the federal government also adopted a pas- sive, hands-off approach, expressing unfailing commitment to the workings of international trade agreements and relying exclusively on Canada’s cost competitiveness and closeness to the US to attract new investment in strate- gic industries.

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As indicated above, however, these traditional assets are not sufficient, given the current North American economic and policy context, to sustain Canada’s share of total automotive investment and employment. And government was initially slow to respond to the structur- al challenge facing the industry. In the wake of increasingly urgent expressions of concern from virtually every stake- holder in the industry ”” automakers, parts producers, the CAW, municipal governments, and many independent analysts ”” both federal and provincial officials are now moving to update and strengthen Canada’s automotive policy framework. For example, the federal, Ontario, and Quebec governments last year formed the Canadian Automotive Partnership Council to bring together industry stakeholders to develop a new vision for the industry. And the Ontario government recently announced a new $625 million initiative, funded over 5 years, to assist in recruiting linchpin automotive investments to the province.

The federal government is widely expected to develop some similar initia- tive. This progress is encouraging, and hopefully will keep Canada ”œin the ball- park” for new auto investment and pro- duction. But it will require an integrated, multidimensional policy approach for our industry to retain its position of global leadership.

As federal and provincial officials consider their next steps in design- ing a modern automotive policy for Canada, they should revisit the key les- sons from the historical development of the Canadian industry. The industry did not develop here because of private busi- ness decisions alone, nor because of free market forces, access to the US market, or a supply of skilled and cost-competitive labour. The industry developed in Canada because governments took active measures to encourage and cajole often reluctant automakers to expand their presence here. Those measures involved both positive incentives for companies considering major Canadian investments (call them the ”œcarrots”), but also the real or threatened application of penalties for companies which did not invest in Canadian production facilities (call these measures the ”œsticks”).

There has been much debate in the Canadian media about the relative merits of providing cash investment incentives to large corporations. Most of this debate has been moot. The issue is not whether or not government will supply cash to automakers in support of major new investments. There are plenty of other channels through which governments can add value to an investment project ”” enhancing its business case in a manner quite con- sistent with government’s overall mandate to facilitate high-value eco- nomic development ”” without hand- ing over a single loonie of cold, hard cash. These initiatives, all of which have precedents in other high-tech sectors of our economy, could include:

• The use of targeted investment funds, like the federal Technology Partnerships Canada (TPC) pro- gram, or Ontario’s R&D Challenge Fund, to co-fund investments in cutting-edge products or process- es. Until this year, the R&D Challenge Fund was off limits to automotive companies, and the TPC program still effectively is;

• Government or quasi-governmen- tal equity investments in new facilities, similar to the Quebec government’s Societe generale de financement (SGF) fund;

• Government participation in financing necessary investments in infrastructure, training, and site preparation and amelioration; and

• The extension of existing technol- ogy subsidies (such as the federal government’s 20 percent R&D tax credit) to include activities which typify the practice of innovation in the automotive industry ”” including more support for proto- typing, early commercialization, and shop-floor engineering and design improvements.

Those who believe that govern- ment should play no role in leverag- ing or influencing private business decisions, and consequently accept that the crucial decisions over the course of economic and industrial development should lie solely with business, will predictably oppose all of these measures as misguided attempts by government to ”œpick winners.” If policy makers had followed this advice in past decades, it is obvious that Canada would not have a major auto industry today ”” like most other smaller developed countries. Despite the numerous advantages enjoyed by automakers in Canada, including high productivity and the cost savings of our public health care system, automakers are shifting investment to other jurisdictions. They will continue to do so unless we adopt an active pro- investment policy.

Government can and should ”œpick winners,” in the sense of identifying strategic, high-value, export-oriented industries for which the social or ”œexternal” benefits of production and employment exceed the private bene- fits accruing to the investing company. Federal and provincial governments already follow this strategy in justify- ing targeted support for various high-tech industries including the informa- tion technology, pharmaceutical, aero- space, and environmental industries. The same approach must be taken for the auto industry ”” Canada’s most important high-tech industry ”” if we want it to continue to generate the economic and fiscal benefits we have come to expect from it.

Far from constituting ”œcorporate welfare,” therefore, the careful use of these ”œcarrots” is actually a form of enlightened self-interest. If we want the huge spinoff benefits that come with auto investments and produc- tion, then we need to collectively invest in attracting those investments. Indeed, the financial return for gov- ernments would be positive, not to mention for the economy as a whole. For example, imagine a typical auto assembly plant employing 2,500 workers on site and another 1,000 in directly linked parts facilities. The fed- eral and provincial governments together take in at least $50 million per year in income, sales, and payroll taxes from those 3,500 direct employ- ees alone ”” let alone from the tens of thousands of other Canadians whose jobs depend indirectly on the com- plex. Government could support the investment with $250 million in assis- tance for training, infrastructure and technology (a level of support that is comparable to what was typically pro- vided to major Canadian investments in the 1980s and early 1990s), and recoup the funds within five years through taxes paid just by the facili- ty’s direct employees. Counting indirect government revenues, the investment is paid back much faster. It hardly seems prudent for governments to stand by repeating slogans about fiscal discipline as linchpin investments continue to migrate to other jurisdic- tions, with a hugely negative impact on the government’s own bottom line. If modest participation by gov- ernments can assure that a propor- tionate share of these investments will continue to occur in Canada, then it is obviously a solid financial decision for governments to play their role.

Experience has painfully shown, however, that even the provision of attractive financial incentives will not guarantee that Canada retains its share of new auto- motive investment. For example, DaimlerChrysler recently announced that it would not proceed with a hotly anticipated new assembly investment in Windsor, despite unprece- dented participation by the CAW and major suppliers and government financial incentives that were reported to be in the range of $250 million. The company’s internal priorities and strategies out- weighed the commitment it had made to the Windsor investment. This experience will be repeated if Canada pins its hopes for new invest- ment solely on the bottom-line self- interest of the automakers.

What about the ”œstick” in automo- tive policy, then, to supplement the use of the financial ”œcarrots”? In the past, the most important stick that govern- ment could wield was the application of active trade policy levers, aimed at managing import flows or motivating inward foreign investment. To be sure, Canada’s free trade commitments have constrained the extent to which our federal government can invoke trade policy remedies to press reluctant automakers to expand their Canadian presence. But there is surely still plenty of room for a more creative and active approach. For example, an important motivation for the recent investments by Asian and European automakers (like Honda, Toyota, Hyundai, and Mercedes) in the US was behind-the- scenes pressure applied by the Clinton administration to expand their US oper- ations or else face import restrictions, focused especially on high-margin lux- ury vehicles. Winning protection from future US trade actions continues to be an important factor in motivating the new automotive investments currently occurring in the US south. Canada could adopt a similarly proactive approach in dealing with importing companies, rather than signalling that our $50 billion auto market is up for grabs to all comers, with no strings attached. Canada’s trade deficit in auto- motive products with Europe, Asia, and Mexico reached an all-time high of $16 billion last year, and it now offsets over half of our strong automotive trade sur- plus with the US. Surging imports from companies with no production pres- ence in Canada must be regulated, and the federal government continues to possess both formal and informal tools that would allow them to do this.

More broadly, it would be possible to devise a set of measures which would be similar to the Auto Pact in their application of both ”œcarrots” and ”œsticks,” but neutral with respect to the national origin of companies and prod- ucts (and hence consistent with Canada’s existing trade commitments). Imagine a revenue-neutral system of taxes and grants aimed at stimulating made-in-Canada production and inno- vation in the auto industry. All pur- chases of new vehicles would be subject to a new tax ”” perhaps 10 percent ”” levied at the wholesale level and paid by the manufacturer. At the same time, a new schedule of generous incentives would be introduced to sup- port investments in physical capital, technology and skills by automakers in Canada. Companies which invested heavily in Canada, proportionate to their sales here, would receive back as much or more in incentives as they paid in the new tax, with no impact on either vehicle prices or on their corpo- rate bottom line. Companies which only sold their products in Canada, with no commitment to developing a Canadian production presence, would face only the ”œstick,” with no access to the ”œcarrots.” They might respond accordingly by making investments in Canadian facilities, but at any rate their ability to penetrate the Canadian market, with no strings attached, would be con- strained by the new tax.

To be sure, this approach goes very much against the grain of the hands-off, laissez-faire approach that has dominated Canadian industrial policy mak- ing in recent years. But it’s this very approach ”” with its all-encompassing faith in the ability of free markets and supply-side measures alone (such as public support for skills, R&D, and innovation) to stimulate the devel- opment of high-value industry in Canada ”” that has put us in the present predicament. The auto industry is a rare high-tech success story for Canada. It is one of a tiny handful of high-value industries in which Canada exports more than it imports, in which we are more productive than our trading part- ners, in which we share in the huge eco- nomic and fiscal spinoffs of high-tech success. Hands-off, laissez-faire thinking did not give us this industry: active, smart policy interventions did. And unless and until we reinvigorate those interventions, it is clear that Canada’s success in this crucial industry will steadily become a thing of the past.